The Most Insightful Hour in CRE Part 19 with Dr. Peter Linneman, Leading Economist, Professor Emeritus, The Wharton School of Business
Willy Walker: Good afternoon, and welcome to the Walker Webcast. I am in our Denver Zoom room, and my great friend Peter Linneman is joining me from his office in Philadelphia, Pennsylvania. A couple of things before we start.
I had a really interesting conversation last week with Denver Mayor Mike Johnston about Denver attracting development into Denver, what to do with the downtown core, homelessness, safety, and security. And I think one of the most interesting things about the conversation with Mayor Johnston was that many of us in the commercial real estate industry have been, if you will, dealing with those issues for quite some time there. The homelessness issue is something we've talked about; Peter, and I have talked about it. The crime issue is something that many people who both invest and live in core cities have been dealing with and focused on for quite some time. I thought the interesting thing about my conversation with Mayor Johnston was what Denver has done to try and work and successfully work on those two issues over the past year to get 1,900 homeless people off the street, the 11 encampments in Denver that were held by over 100 homeless people held have all been cleared. And the Denver police force was spending, per the mayor, 64% of its time on calls to those four homeless encampments before they got cleared over the past year. And so you think about what happens because of the chain effect of, “Okay, first focus on the housing, then get the people off the street into the housing, then allow for the police force to really focus on policing again. And hopefully, we can now move to this phase of redevelopment in downtown Denver, getting more investment dollars, getting job growth, and things of that nature.” But I just thought it was an interesting kind of down-on-the-ground, if you will, boots-on-the-street discussion, Peter, as it relates to what needs to happen in some of America's larger cities to make them investable again and start to get some of the issues that you and I consistently talk about as it relates to multifamily occupancy levels, office vacancy levels, crime, homelessness, things of that nature back in order.
One other quick thing before I dive into my questions to Peter. I saw my friend Dr. Mohamed El-Erian in New York last week. And as Mohamed and I were sitting around talking, I made the comment to him that 155,000 people had watched the replay of his Walker webcast. And he looked at me and said, “You jinxed me.” And I said, “What do you mean I jinxed you?” He said, “You wrote me when we got to 150,000, and we've just sort of flatlined since then.” He said, “Peter Linneman still has 260,000, and Ivy Zelman still has 170,000 replays. So we've got to do something to try and push my numbers up. And I poked at him a little bit, saying, “You're on CNBC too much for people to go back and watch the Walker Webcast.” But I thought it was quite fun that Dr. El-Erian was focusing on Peter and Ivy as guests and having had lots of views of those webcasts.
Dr. Peter Linneman: Willy, just tell him to do what I do. I just sit there and click.
Willy Walker: Exactly. We both get our relatives to go; just click in and add to the views.
Peter, one of the things that I want to do on this call, which I'm going to put a big caveat ahead of, is that we don't typically dive into politics, and I don't necessarily want to talk about politics. But I do think that the data in The Linneman Letter is so starkly different from the political narratives going on in this campaign that I'm just going to talk about fact and fact. I'm not going to try to talk about one person being right or wrong or whatever. What I do want to bring up in this conversation, though, is the difference between the political rhetoric on both sides of the aisle and the actual factual data that you have in The Linneman Letter, which, at the end of the day, all we're trying to do is give the data to the people who decide to listen to this and watch it on replay to make it so that they can make wise investment decisions. And when you hear out there, it's a disaster and everything's terrible, and the economy's awful, and it's being mismanaged. Then, you look at the actual numbers, and you can make your own political decision about whether you want to listen to it's a disaster and terrible, or do you want to look at the actual numbers? But we're going to go to the actual facts in this conversation. And so I put a big caveat in front of this because I don't want to sound like I'm diving in on politics, but I sat there last night and watched the vice presidential debate, and I listened to two lines of reasoning talk about the economy that in no way on either side match the data which is in The Linneman Letter on this quarter. Let me start here, Peter, and lay it out on one of the paragraphs that you write inside of The Linneman Letter.
“Over the last 12 months through August of 2024, the nation added nearly 2.4 million jobs and 709,000 people to the labor force and increased real retail spending by 2%, and mortgage applications were up by 25%, although industrial production was flat. In addition, we saw average unemployment of 3.9% over the same period. Debt service remains low as about 70% of homeowners are paying 4% or less on their mortgage. Many firms have similarly locked in cheap 7 to 10-year debt. Many observers are finally realizing these powerful facts, which we have noted for over two years.” I sit there and talk to many investors. I talked to many Walker & Dunlop clients who sit there and say, “It's a disaster.” And I read that paragraph out of The Linneman Letter, and I say, “What's happening between, if you will, fact and fiction, reality versus perception.”
Dr. Peter Linneman: Maybe one of my only saving graces over the years is that I am really not political, and I have no political agenda in my career. So half the people think I'm Republican, half think I'm Democrat. I've never been, either. But I do like data, as you know. And the data show what the data show. And I'll give you just before we dive into it, you'll hear this notion that the economy tanked in 2020, and that was Trump's fault. It was not Trump's fault. That was the pandemic and all that went with it. By the same token, you'll hear that the inflation that occurred is all Biden's fault. That's not true either. It was due to the pandemic, the supply chains, and all that. People just need to look at the data. We are still a growing economy. ADP employment numbers came out. They were quite solid this morning. The BLS numbers for employment growth will be solid on Friday. Inflation is down. It doesn't have much to do with the Fed, doesn't have much to do with Biden, doesn't have much to do with Congress. It is the fact that we've gotten the pandemic behind us. Supplies come back, and supply chains have normalized. It would have done that under any administration. Might it have done it slower or faster? That's a hard counterfactual, but I can tell you the data. We talked about this a couple of sessions ago.
Government matters enormously on who wins and who loses. But in terms of the overarching economy, not much. And that's because we've never had good economic policies. It's not like this one has perfect policies, and that one has horrible. They're both a mixture of politically viable compromise policies that are not very good in a pure sense. The economy grows in the end.
Willy, the example I like to use is that if you're in the fossil fuel business, you really would like the Republicans to win everything big that will benefit you as a fossil fuel guy. If you're a renewable person, you really want the Democrats to win big in everything because they're going to favor you. Either way, we're going to go home and turn on the lights. Either way were gonna turn on our car. Either way we are going to fly. Might it cost a little more or a little less, that is third order of fact on the economy. It is a big order effect on who wins and loses but on the overarching economy it is not. That is true across the economy.
Willy Walker: But let me jump in on that before you move off of that, Peter because I think this is back to perception and reality. You're teeing up two very distinct, if you will, policy objectives of a Trump presidency and a Harris presidency and why one of those two industries will win or lose as it relates to overall policy. But one of the things that were shocking to me in the Linneman report, as you very clearly point out, in June, there was a debate between Trump and Biden where Trump talked about drill, drill, drill, and he blamed Biden for not approving the Keystone pipeline. Biden sat there wide-eyed, looking into the camera, and not having a response to that statement. And yet, as you point out in The Linneman Letter, this is very relevant real data; in the month of July 2024, the country that pumped the most oil of any country in the history of mankind was the United States of America at 13.3 million barrels. And as you also point out, if the United States and Canada's oil production were put together, it would be greater than that of OPEC today. So the response there should have been, and again, this is perception versus reality. The response should have been that we didn't need the Keystone Pipeline to increase oil production in the United States of America and put oil prices down to where they are. That wasn't the response. But my point is there's this sense that we aren't drilling enough. And yet, at the same time, as you clearly point out in the data, we've never drilled more.
Dr. Peter Linneman: Willy, the question is, we would have probably drilled a bit more more. By the way, would we have drilled 20 times as much? Of course not. That wouldn't have been politically viable. We would have built a bit more. And that goes to my point. We're going to turn on the lights either way. We're going to drive our cars either way. It might be a little more expensive or less expensive either way. Why are we the largest driller of oil? We're the largest because we're the most economical to do it. And that's the overarching power.
For example, no matter what administration it will be, they'll do things, and I'll complain about them no matter who wins. I promise you, no matter who wins, I'm going to say, “Are you kidding me?” And because they're going to have policies set up. Having said that, there's a reason the US economy is the US economy. There’s a reason we grow. There's a reason that what we're 50% or so of world stock market capitalization: we're almost the dominant share of new and creative companies being created. That's what matters. That's what really matters to the economy, all the other is it matters. Now, there's a whole bunch of stuff not related to economics that administrations and Congresses do. That's a separate issue as well. But you don't come to a guy like me to talk about that.
Willy Walker: Yeah, but one of the things that I think is important is that, for instance, you pointed out this quarter as it relates to bureaucracy and red tape. And so one of the things that I've always looked at that has shocked me, quite honestly, as you look at the actual data is that the underlying economic data is very strong. At the same time, consumer confidence has never gotten back to anything close to where it was in 2019. So I have always sat there and said, “That's a reflection of the image of President Trump being a strong leader, being a great businessperson. And he has sort of won that image which gets people to a consumer confidence number of, I think was 132, and we're now down to 103 or 104, even though the underlying data would tell you the economy's really good.”
But in this letter, you dive into a point that I hadn't sorted. I thought that that was a reflection of people's thoughts of Trump versus Biden as a leader and consumer confidence in the future of America. But you point out that the increasing regulatory burdens weigh particularly heavily on small business owners without the clout, scale, and expertise to be able to deal with those increased regulatory burdens. Do you really think that the increased regulatory burden of the past three and a half years of the Biden administration has caused that consumer confidence to decrease at the levels it is?
Dr. Peter Linneman: Yeah, I think that has especially small business confidence, but also a bit consumer.
Look, I did a study in 1977 or 1978 on mattress flammability standards, of all things. And what I found was that initially, I won't go into the details, but what I found was that the originally proposed standards were quite draconian. The entire industry opposed it. The final standard that was adopted by the big companies because they had already met. They then became big supporters, and the smaller mattress manufacturers had to scramble because they hadn't already met these standards, etc., and their regulatory burdens went up. They didn't have the lobbying clout. And by the way, absolutely nothing happened to the number of deaths and injuries associated with mattress buyers. And I think that captures what goes on. Initially, a regulation gets proposed. The entire industry hates it. Then the lobbying, which is largely done by larger firms, wins something they can live with, and the small people don't get much say in the lobbying they don't have the wherewithal for the compliance, and it squeezes them out as competitors not totally.
So, the Obama administration, especially in the last 40 years, was extremely regulatory. Just look at the pages in the Federal Register. There are other metrics. Trump greatly reduced it. It was still high but greatly reduced it. The Biden administration has just surpassed the Obama administration's highest year. Those have to be complied with. Those had to be lobbied on. That's the way to think about it. And that used resources, and big firms are better situated with those resources than small firms. That's why small business optimism, I think, is really quite low. They're dealing with all of this stuff.
I don't know about you. We just did this compliance reporting thing that all businesses had to do. I don't know who's going to use it. I don't know how it's going to help anybody. But we had one of our staff people spend, I don't know, 15 hours pulling together from my little entities. The information that's needed is going to sit there like that final scene from the first Indiana Jones where it's boxes of stuff. Nobody, and yet I had to do it.
Willy Walker: Look, you're preaching to the choir on that one. As a publicly traded company, we have had the SEC do their annual exam of our asset management company here in our offices for the last two days. By the way, I understand why we have to do that. We fully comply with that. I'm not trying to say that we shouldn't do that.
Dr. Peter Linneman: By the way, I'm not suggesting all regulations are wrong. I do always find it interesting that we passed a regulation, and all the politicians stood up and this is the greatest ever. It's going to save the consumer or whoever. And then, nine months later, they're back with a new savior. But why didn't you do that originally?
Willy Walker: Yea. I want to go to the macro level first, and then I want to dive down to the individual consumer. Then, I want to dive down into real estate because I think the macro view is very important. But I consistently get friends who watch this saying, “Yeah, but you and Peter are talking about GDP per capita and things like that, and the billionaires in the number distort all the numbers. It's not actually the consumer.” I want to do high-level stuff first because that's going to get to debt and inflation and interest rates. Then, I want to go down to the consumer and the strength of the consumer, and then I want to go down to actual assets and asset classes, cap rates, growth, and things of that nature.
But to just round out what we've been talking about at the top, from the pre-COVID peak to today, real GDP is up 9.4%, from pre-COVID peak to today's real per capita GDP. And remember, people are listening to this; I'm talking about real numbers. We're taking inflation and adjusting for inflation. So these are real numbers. So, real per capita GDP is up 6.9%, and real retail sales are up 10.1%. Real median home price is up 53.8%. One of the things that I think is incredible, that this does show as it relates to the politics of who the Democrats are speaking to and who the Republicans are speaking to.
Last night, there was a big conversation in the VP debate about the cost of housing. At no point did either one of them say that 65% of Americans own their home, and 80% of them have a locked-in mortgage under 4%. And they're thrilled about the fact that the median home price is up 53.8%. They're all talking to the people who want to buy into that market to graduate from multifamily into single-family or want to upgrade from one single-family home to the next. And not focusing on the people who are sitting back and saying, “I'm thrilled I own a home that's appreciated by 53% over the last four years.”
The final one is real per capita household net worth, up 12.7%. Obviously, that housing data point has a lot to do with that number. Peter, as you look at all of that, one of the things that a lot of people are concerned about is the national debt. And you have been very consistent in saying that you don't think that the national debt is anything for all of us to get that concerned about. And in this Linneman letter, you look at its net household net worth, which is that 12.7% up number, is it about $165 trillion. And you net out of that the debt that we owe to foreign owners of US debt because if you paid off all the debt, we'd be paying ourselves, both individual Americans as well as inter-governmental play. That drops it down to $155 trillion. And you underscore that by saying, “$155 trillion is the net worth.” But then you added something this quarter that I'd never seen you do before that I thought was fascinating, to which you said, “That's net. Let's look at what true wealth is by doing a DCF (discounted cash flow) on GDP.” And to your estimation, if you did a DCF on GDP, the value of the American economy is somewhere between $600 and $800 trillion. And when we get into these numbers, it's hard for anyone to really pull them back. But I guess at the end of the day; there are a lot of people really concerned about both our deficit spending and the overall amount of debt outstanding. And you continue to say don't get freaked out by it.
Dr. Peter Linneman: Politically, but not economically. You get it. We can pay off all our debt and still have $155 trillion in household debt. That's staggering. And by the way, we should never pay off the foreign part of that debt because it's our free option to stiff them. And you would never want to give up that option.
Willy Walker: What do you mean by that?
Dr. Peter Linneman: If we went to war with China, or it was just for an example. Do you think we would be making interest payments to them on the debt they hold? Just as an example, I'm not saying we should go to war with China.
Willy Walker: Do you think that actually plays into foreign policy thought?
Dr. Peter Linneman: No. But I'm sure it would play if it happened. It would end if it happened. That's all I'm saying. But this is not new history. The optionality of stiffing. Let me do it this way. I'll do it differently.
If you take out intra- governmental debt, you probably have the numbers in front of you, but it's like $26 trillion or something like that. Think of that as, let's just say, you've got a building that has $26 million of debt and an income of $28 million. Our GDP is $28 billion, so that's roughly our income.
Willy Walker: The income to the federal government. You and I have talked about this.
Dr. Peter Linneman: That debt is not backed by the federal government; is backed by the full faith and credit of the citizens of the United States today and into the future. That's a matter of fact. To say that it's only backed by current taxes is a little like saying, “Do you have a lockbox associated with your mortgage payments?” That may hold back two months or a quarter. That's the analogy. You have a building with $28 million in income and $26 million in debt. Is that a high-leverage building or a low-leverage building? And you would say unbelievably low leverage.
Willy Walker: It's not a 1:20 debt service cover, but it's fine.
Dr. Peter Linneman: That's the total debt we're talking about. So these REITs, which are low-leverage players, if they have debt five, six times EBITDA, that's considered leverage. We've essentially got debt to EBITDA on the nation of 0.8. That's low leverage. That's all I'm saying.
Willy Walker: Right. I hear you on that. And I actually went to a DSCR and you're talking about basically an LTV.
Dr. Peter Linneman: Yeah. And so the issue is not the debt. By the way, let's take a building; $26 million is a lot to borrow for a building. Depends on whether it's a building that's a piece of sh** or a good building. Are you getting your money's worth? That's what it depends on.
Willy Walker: And that's where you go off on government spending and basically saying, “Look, it's only a concern and that we are profligate spenders these days, and there's a lot of misguided spending being in the deficit.” But as it relates to an overall financial calculus, it shouldn't concern us.
Dr. Peter Linneman: And by the way, wasteful spending is wasteful, whether we have a surplus or a deficit. It's wasteful either way. You would only worry about debt. Think of the buildings. You only worry about it is you buy a bad building, you think you are going to get $28 million in income, and you get nothing, and now you're in trouble. That's not us. The second is I can't afford it. So go out and by a G5. And I borrow to buy a G5. The leverage on the G5 might be four, which might be okay, but I can't afford it. I just literally can't afford it. We can afford it.
Zimbabwe can't afford their debt. That's the real problem. They don't have a future income. They don't have a current income. We have a lot of income. But the problem with our debt is no one wants to pay it. 355 million citizens, I shouldn't pay it because I'm 73 years old. Your kid shouldn't pay because they're a student. Somebody else shouldn't pay it because they're working on some advanced chip research. Somebody else shouldn't pay it. The problem is not that we don't have resources. It's that everybody's got a reason why it shouldn't be them.
Willy Walker: But to your point, as it relates to, I think the piece on this that I think is most important to commercial real estate investors is the ten years now down; I think we looked at it right before we came live it was at 3.75, and it had been down to 3.62 just before the Fed's 50 basis point rate cut. Got up to 3.80 a day or two ago. And the question would be, Peter, let's forget about the short end of the curve for a moment and just focus on the long end of the curve. As it relates to a desire to continue to buy US ten-year treasuries. Is there a point where foreign investors and domestic investors say, “I'm concerned about deficit spending and the US debt where I risk off on buying the ten-year bond Because I don't know if the United States is going to be able to pay me back for that thing. And therefore, you get rates going up because there isn't an ask for that paper.” Does that concern you at all, or do you think that the market continues to have a demand on it? Let's take a window over the next three years that kind of regardless of who wins in November; we're going to run trillion dollar deficits on an annual basis that you don't have that fear of both foreign and domestic investors saying, “A 3.75 or 4.20, 10 year is not something that interests me as it relates to return.”
Dr. Peter Linneman: Yeah, I don't worry about that a lot. I worry about it in a month or something like that. There could be a window, but not long term. Why? As long as the rest of the world continues to grow and create wealth, particularly in lesser places in terms of income like India, Africa, and Guyana, Why? Because take Guyana, which has this huge oil refinery and their politics. If you just got $100 million for the first time in history in Guyana. Where are you going to put a big chunk of it? You're going to put a big chunk of it in the US because its assets are safe, including US treasuries. And that's what fundamentally drives us. If Guyana was safe, that would be different. If you win the $100 million lottery, how much money are you going to invest in Guyana? None. If someone in Guyana wins the $100 million lottery, they're going to invest most of it in the US, in Treasuries, etc. So as long as that money gets created, quote overseas, we may not be wonderful, but we're a lot safer, etc., than the places that are particularly growing wealth, which tends to not be so much Western Europe, which is relatively safe. It tends to be the non-Western Europe that's growing wealth. I don't worry about that. And in fact, I think when we come back, I assume you'll have me back in a quarter, which is a presumption.
Willy Walker: I'm going to have to kiss your feet, I think. But we'll talk about that next.
Dr. Peter Linneman: Hopefully, that's the kiss session. No, I think when we come back, the ten-year Treasury will be below three and a half. And people say, “Why?” Because it's going to become increasingly clear that inflation is quite low. It's notably overstated at this point, and it's even more overstated now that it's been in the past. And that's going to sink in slowly. And the other thing is, as the short rate comes down, the incentive to invest short versus long will swing. So, for the last year or so, you were able to invest short, and you weren't getting eroded much by inflation. As an investor in the shorts. So that drew some investors away from the long, including real estate, by the way, as a long but also ten-year Treasury as a long.
As the short-term rate comes down, that money for nothing disappears. And you're going to have to go longer if you want a return. And that includes the ten-year treasury. That will put more money in the ten-year Treasury as it rotates out of short into long, which will bid up prices and lower the ten-year yield to somehow lower them to 2.4. But it's going to bring them down below 3.5. And I think that takes two more cuts to really take effect. It's not rocket science that money would rotate and when it does the relative pricing changes.
As that same phenomenon occurs, Willy, then with a lag, you're going to see money moving into all other kinds of long assets, of which real estate is one of the major. And as it does, money will flow. And I feel pretty comfortable that if we come back a year from now, something that has a five cap today will have like a 4.2 cap a year or so from now. Why? Because money will flow back to long-term assets. And as it flows, pricing comes down. And it's interesting. Remember, falling cap rates in these models are self-reinforcing because the cap rate comes down a bit, and your exit cap rate comes down a bit. So the price that you can bid goes up. And there's a kind of self-reinforcing analytic dimension that's always been one of the strengths and weaknesses of these models. So I think we're just at the early phases of this rotation out of short and long.
Willy Walker: So, there are a couple of things in there. One, you've previously said that there's about $6.5 trillion sitting in money market funds today. And to your point about shifting from short investments to longer investments, some of that money will come out. But one of the things you've been very clear on in the past is that you're still on this. You don't need to explain very much that don't expect all $6.5 trillion to flow out of money market funds. We might get $2.5 trillion flowing out of that into longer dated, but you're probably not going to dip below $4 trillion. Is that a fair estimate?
Dr. Peter Linneman: Yeah. We've never had this higher level, so it's a little hard to be precise. I don't expect it all to disappear, but it's not hard to envision $1 to 2 trillion rotating. That's a lot of money at the margin.
Willy Walker: No, I got you on that. So then the next one is this.
So I hear you talking about 3.75, ten years today, and you wouldn't be surprised if it gets down to 3.50. But you also state very clearly in the letter that the short-term rate should be 75 to 100 basis points above basic inflation. If you're going to set your target one when inflation is normalized, are you setting it to 2 or 2.5?
Dr. Peter Linneman: I'm setting it at about 1.5. Let's do facts. You love facts, so here are the facts. If there are two major measures of inflation, CPI and Personal Consumption Expenditure indexed. CPI is the higher of the two. So I'll just use it. So, over the last year, CPI is basically up year-over-year headline, with no adjustments running at about 2.5%. Over the last four months, all you have to do is go to the CPI index numbers, and you may want to check me out. Just go to Google, type in FRED CPI, it'll bring up the chart and see what it was four months ago and see what it is today. And you'll see that it is the exact same number, not exactly. We've had no inflation over the last four months.
Willy Walker: But owner equivalent is up.
Dr. Peter Linneman: Then you say there's this bizarre concept that we've talked about called owner equivalent. And by the way, over the last year, something that no one has ever paid, and no one even really understands what it is except a few nerds. And they can't even explain why it's in the index. And Europe leaves that out of their data because it makes no sense. And yet it's 24% of CPI, and it's up 6% year over year. Now, you're a homeowner. I'm a homeowner. I have no idea what rent I'm paying myself, much less. How much is that rent on not paying myself up over the last year, but it's 24% of the index. When you take out owner equivalent and only live-in items that people actually purchase, it is not a lot to ask of an index. Only include the items that are purchased by somebody. Somebody is actually paying for them. The inflation rate over the last year fell to 1.1%, not 2.5%. And by the way, when you go to the last four months, what you'll see is that it falls slightly negative.
Willy Walker: Yeah.
Dr. Peter Linneman: And you go, why do I say inflation's going to be stabilizing out at 1.5%? It'll be a bit negative-ish in the way we're talking about for the next few months. It'll be because that's what it was for the preceding 30 years once the world adjusted. If inflation is 1.5% and you add 75 bps for risk floating around bouncing, you get to 225. If you then say the ten-year Treasury should roughly be 150-200 bps over inflation, you get somewhere between 3% and 3.5% bouncing around depending on money and risk and all this kind of headline and so on.
Willy Walker: Do you think there's a floor on that then, Peter? We got to the normalized yield curve at some point. We got to get there. And you're saying they're obviously cutting, and there's a lot of room still for them to cut off sharing work.
Dr. Peter Linneman: That's the real point.
Willy Walker: I think it's the transition from a 5.25 Fed funds rate to what you're now prescribing to be at a 2.50 Fed funds rate. And as that comes down, what happens to the long end of the curve? And it has felt like you and a bunch of other people have said, “They'll continue to fall in lockstep.” And I'm sitting here going, you got to get back to a normalized yield curve.
Dr. Peter Linneman: Not lockstep. We're at 4.75 to 5.00 on the short. Let's just call it 4.75, and ten year is 3.75. We just said. What will happen? I said, “I think the ten-year goes down 3 to 3.5, let's call it 3.25. I don't want to be that precise. So it goes 3.25, but the short end goes down 2.25. And, of course, that's how you get to a normal yield curve. And they could do it much faster than they're going to do it. I suspect they're a little embarrassed. They should be highly embarrassed. They're way late.
Willy Walker: Hold it. How can you say they should be highly embarrassed? They've threaded this needle; for the last two years, everyone's been sitting around going you raise rates that high, and we're going to crash down into a recession. We're going to have huge unemployment numbers, and you're going to tank the economy.
Dr. Peter Linneman: You never heard me say that.
Willy Walker: I realize you didn't, but I'm just talking about you saying, “They should be highly embarrassed.” They were already embarrassed about acting too late to deal with the inflationary pressures that you clearly saw coming in. But by the way, you also were a little late saying, “We needed to move rates because of inflation coming.” You were reading the same data. You got a little late. They got a little late. But then, since they decided to take action, their actions have turned out to produce an economy that you, being an exception, thought they could actually do. Why do you think they should be walking their heads down?
Dr. Peter Linneman: Let's go back. You dropped a number earlier, which is true. And like a 9.4% increase in real GDP. “If you would take, it's basically been four and a half years, since that number.”
Willy Walker: Going to say we should have stayed on trend.
Dr. Peter Linneman: That number would be almost two percentage points higher. That's why I never saw this crashing. Now you go further. By the way, I never thought the rate should be other than maybe in March of 2020 or April of 2020. Who knows what rate it should have been. But as you got too mid-2020, it made no sense to have a zero rate. I'm not saying it should have been zero. That's not much. But it was clear to me that inflation was all about the supply chain. You shut the economy down. By the way, monetary policy might have had some influence, but it was all about the supply chain. All you have to do is watch the supply chain index, and as it goes down, inflation will go away. The Fed claiming credit for inflation going away is like someone has the flu, and you give him antibodies, and then the doctor takes credit, saying, “The antibiotics cured it.” It didn't, but if you had pneumonia, you would get some credit.
Willy Walker: But hold, that then says Peter, if they'd done nothing, we would still be in the same place. And I just cannot agree with you that if they'd kept the rates at zero, we wouldn't have rampant inflation going on in the economy today, and we wouldn't be dealing with a vastly different economic outlook.
Dr. Peter Linneman: We will be in a better place because of the problem. Historically, if you look back upon the rationale and the data when short-rate increases are used, is when the economy is above trend. And when you look at why it's above trend, you'll generally find that one or more of the following three sectors are way above their trend. Single-family housing, or auto, or manufacturing other than auto, those are the three sectors. Televisions. They get overheated. And when they're overheated, they get the economy overheated. And we'll use interest rates because homebuilders use short-term floating-rate money. And when the interest rate goes up, they make fewer homes. Second, with autos, people happen to auto manufacturers on their line of credit, and two-thirds of them buy autos with loans. So it cools the auto. And the third is manufacturing similar lines of credit. You cool those three sectors because they're identifiably overheated. If you look at when the Fed started raising rates above, let's say, 2%, auto massively under heat. If you look at housing in terms of volume, not pricing, that volume was massively under trend. If you look at manufacturing, it was still below naught. And they cooled all three of those. So, it is true that the increase in interest rates cooled single-family housing, which kept us further below the trend. It's true that it cooled auto, which kept us even further below trend. That's 9.4 versus 11. So it is true that it cooled manufacturing. None of those three sectors needed cooling. None. We would have had an economy closer to recovery. By the way, how does that matter to listeners? There would have been more demand for your product. That's how it would have mattered. And by the way, your short-term interest rate wouldn't have been so ridiculous. It wouldn't have been zero. It would have been 2.5%, 3%, 2.25%, some number like that. And that is to say, “You wouldn't get nauseous from taking an antibiotic. And that side effect made you nauseous.” And by the way, we had higher employment and more demand for real estate as that higher economy. We would have gotten back closer to the trend. Inflation would have disappeared because it was about supply chains. How did raising the rate have any notable impact on medical. So, I just had an ablation the other day, and the doctor tells me, like on a Monday, “You're in A flutter, and you could have a stroke, and the chance isn’t very high. But yeah, I think an ablation is wise, so you don't have a stroke.” The next words out of my mouth were, “Were not, let's wait and see what the Fed does with interest rates.” That's absurd. It didn't slow medical.
Willy Walker: I got you. And your point is well taken. I think the thing to keep in mind is that while you are criticizing the fact that we've only grown 9.6 versus 11.5 or whatever the number might be, we have outpaced every single other country on the face of the planet. Relatively speaking, we've done plenty well while the rest of the world has gone even slower than us.
But let me jump out of that, Peter, into two quick things. The first is your canaries' look, which is the forward look, which has always been great. You've got every canary alive and well hanging out in its little cage inside of the coal mine except for mistaken Fed policy, which has three of the five birds dead. You're being very consistent there. But I think it's important for people listening to realize that the outlook right now as it relates to a number of the things that you just talked about, overbuilding and single-family, stupid valuations, that empty space is worth more than occupied space, all the things that we've seen in the past that have created bubbles and the things that the Fed in the past has had to respond to. As far as economic indicators, that would say the economy's getting too hot, and you've got none of that on your outlook right now.
Dr. Peter Linneman: And that's the point, which is we're still below trend. We're still early in the recovery, for example. Recoveries tend to last six or eight years. The one that ended because of COVID-19 was in its 10th year. We're in the third year. We're still early in this recovery. We’re still below the trend. What happens as interest rates come down. We've probably got 10 million or more autos that we haven't purchased over the last four years. That is, just take auto. All we have to do is try to get back the autos we normally buy, plus the ones we didn't buy over the last four years—huge boost to the economy.
Willy Walker: Do you own stock in an auto manufacturer?
Dr. Peter Linneman: Only through an index fund.
Willy Walker: There are a couple of things related to economic growth. You do pin in it that 86% of the gap in GDP is specifically due to a lack of housing and autos. If that general trend plays in, if someone wants to play a macro play on the recovery of the economy, but you use the data point, which, when I read it in the letter, just jumped out at me, which was that our typical recovery cycles are 6 to 8 years and we're only in year three. I think our recovery is three weeks. It's so funny because I read that, and I'm like, “Hold on a second, three years?” If I were working at Apple, I'd be like, “Yeah, it's been a nice recovery since the pandemic, and things continue to go.” But for most people listening to this and in the commercial real estate space, we ain't in year three of growth. We're just starting the next cycle now. I was sitting there going, I literally wrote in my notes, and Peter said, “Three years.” I'm talking about three weeks.
Dr. Peter Linneman: I am being technical, roughly to the bottom of GDP is one. Secondly, if you said, “Okay, from when GDP got back to its previous high, which is another metric you could use, would you still come up with six to eight years.” And you're right; you used that really in the second year because it took longer. If you go to real estate, it's a capital-intensive business. When the Fed said, “We're in no hurry to raise interest rates,” and then basically, what was it, seven weeks later, that started the fastest increase in they wrong-footed capital markets. Is it a surprise that if you're very dependent on capital, you don't even need to know the business. A business that's extremely dependent on capital, and you completely wrong-footed the capital markets. Forget whether it was right or wrong that they wrongfooted them, but it was wrong footed. Is it a surprise that it's going to be a bad window for them? It's not. And that's where this research that I've done on it’s the flow of money. And if you know, you've been around a long time. Not as long as me, but you know that every time capital disappears, it gets ugly. It doesn't matter why capital disappears. When it disappears, it gets ugly. And when capital comes back and if it really flows, it gets quite good. And we're still in a period that's lasted longer than I thought. And that's because the wrong footing was deeper than I thought. I also misevaluated, I think one thing. I thought that all this dry powder that existed, whether it was in the money center banks with unused reserves or in private equity, would have come out sooner. And I've come to believe, and I've written about this, I'm not sure I'm right, but I've come to believe, “Yeah, there's a lot of money there. They're not paid to take that risk. They're paid to take risks, but not that risk.” And what is that risk, investing when others are not investing. Essentially, what they're paid to do and the market, I think, is more accurate to say, “They're paid to take the risk of investing when others are investing, then they're paid to take the risks of investing.” There's a self-reinforcing dimension of not investing, but there is a self-reinforcing dimension as they start to invest in the other direction. And then I think you're going to see that. That's why I think cap rates are going to fall as money flows. The short rate is a key part of that.
Willy Walker: On that, the LREI has been a really good indicator. In your spring of ‘23 issue; we go back a year and a half, and your forecast for multi, cap rates we're going to go up 50 basis points. They've gone up 65 basis points. Office, your expectation was up 30 basis points. You underestimated that one by quite a bit at 160, industrial up 30 results 54. So, the model was clearly correct as it relates to where cap rates were going to go at that point, given the capital that was pulled out of commercial real estate. Right now, we're looking at banks that have unprecedented amounts of capital, private equity investors in commercial real estate with unprecedented amounts of equity, and dry powder. And you're very clear in the letter saying, “We are at the beginning of the next cycle, and we should see capital flows coming.” I was surprised that you still saw two things. One, you still see office cap rates continue to go up and not start to revert back down. And second of all, that your projection right now; I think it's annual. So, in the next 12 months, there will be only a ten-basis point reduction in multifamily cap rates. That surprised me as being quite so.
Dr. Peter Linneman: Okay. Let me take the latter first. I believe it'll be larger than that, but “The mechanical model.” But remember I said earlier, I think something like a five cap a year from now, is going...”
Willy Walker: You dropped it down to 4.25.
Dr. Peter Linneman: And the reason is I think the model under-assesses how much money will flow as the short-term rate comes down because the real rate has been so high on short-term money by historical standards and because there's so much money on the sidelines. So you can imagine a model that can't take all that into effect, saying 10 or 20 basis points. But when you look at it, you say, “I'm not captured by my model. I think more money flows. And if more money flows, you get more.” Now, in the office, it's a lot more difficult because, in addition to dealing with rent and occupancy, it's in the penalty box. And I think it stays in the penalty box longer than the historical norm. This is again, the model may say one thing, but I think it's something else. This is because historically, when the office was in the penalty box, so was Warehouse, so was apartment, so was hotel, and so was real estate. Therefore, if I wanted to invest in any of those, any are fair game. This time, I can invest in apartments and warehouses. I can invest in hotels. I can invest in retail without going to all the unanswered questions about the office. And therefore, I think it will lag more than normal. It's becoming more out of sync simply because it's so out of sync in terms of being in the penalty box.
Willy Walker: I think you're right. I would like to say that I think that the office recovery has actually begun. And I think that, to your point, capital flows won't go there, which will keep cap rates high for quite some period of time. But for those that can get the financing to make a play in that space, we'll see massive cap rate reduction over their whole period because, at some point, it's reverted, the numbers are back, and capital flows to it.
Let me jump to cities because you do your city analysis of red hot, hot, stable, and bad markets. And I looked into the data, Peter. And so first of all, you only have Vegas as solid, and Fresno as weak. For the rest, you've got 31 MSAs as red hot, and you have 16 MSAs as hot. But as I looked into the data, I was sitting there, and I was looking at DC and Baltimore, were number three and four on your list or something. And the reason you have them there is because they've got low unemployment levels, but that's because no one's moving there because no one wants to live in Baltimore or DC. And as a result of it, you've got low unemployment because they've recovered back. So I went to the right-hand column on your list, sat there, and said, “Who's actually adding jobs?” Because, like DC and Baltimore, they both actually aren't fully back to pre-COVID employment. They're very close. They're at 96% and 94%. But they haven't even replaced all the jobs that were there pre-COVID. So I went and looked at those MSAs that actually had 2X growth where employment was pre-COVID. And so in places like Salt Lake City, which is up 210%, Raleigh up 213%, Austin up 246%, Dallas up 196%, and Phoenix just behind that 195%. Those are the ones that I would think investors are sitting there saying, “Look, the unemployment numbers really aren't the leading indicator. It's growth, where capital flows are going, and where population growth is coming. And it's very clear in those cities that it's happening, not necessarily the Pittsburgh, Boston, Minneapolis, and DC, which all haven't gotten back to their pre-COVID population numbers.”
Dr. Peter Linneman: I'm not going to defend Baltimore, just so you know. And obviously, I think the other cities and metropolitan areas that you named are all high-growth markets. Several of them are working through. If you go to Nashville, for example, the problem in Nashville apartments isn’t that there aren't a lot of new leases being signed. It's just that there are even more apartments available because of the spurt. There is fundamental high growth. It will absorb it. It'll take a little more time than people thought. It'll do fine. The same is true for Austin, especially downtown Austin. They'll do fine; it takes a little time. You have to survive because they have fundamental growth. If you said to me, “Pick a market that you think's going to really surprise beyond the data, if you will.” It's the DC Metro. And that's because I'll tell you why. I'm serious.
Willy Walker: I know you're very serious. As someone who grew up in Washington, DC, and who spends a lot of time there, I can't wait to hear the reasoning behind it.
Dr. Peter Linneman: The reasoning is that if you look across the country, you've got a lot of mayors and governors, including Democrats, by the way, like rock-ribbed Democrats who have, like our new mayor in Philadelphia, who said, “Back to work gang, come to the office.” rock-ribbed Democrats as well as Republicans, have said back to work. No one is touching the federal workforce because they don't want to touch it before the election. I think after the election, no matter who's elected, it's not like the first day after, I'm not trying to suggest that it took, for example, I'm going to do this from the memory of Philadelphia's mayor, she was in, I don't know, two months, month and a half. And then she said, “Back to work. We really need you.” You know, the DC mayor is begging for it. And I think that DC has a real chance to surprise on the upside because all you need is a president who says, if you don't want to work here, that's fine. We can cut our payroll if you want. But if you're going to work for us, you have to come to the office.”
Willy Walker: Do you think that comes on either outcome as it relates to the election? I'm fascinated by this. It's very clear you can assume that Trump would do that, but I'm not so sure that Harris would do that.
Dr. Peter Linneman: If you made me, I'd say, “I don't know what 80% of the Trump would do that, and 55% if Harris wins,” and the only reason I say is you've got a number of Democrat mayors after the election. After they were elected, they said, “Come back.” The interesting thing is you have, and I'll take Philadelphia just as a microcosm. She said, “You got to come back.” She didn't say it before the election. She didn't run on it. She didn't say it. The minute she announced it. The union of the Office Workers opposed it. The other city worker unions all supported it. Interestingly, the garbage workers and sanitation, people cleaned the buildings, etc., saying, “Good.” And it's not as pure a loser as it looks. But they're not going to do it before the election.
If you told me that it was only Republican mayors who have done this for governors, I'd say, “Well, then it depends strictly on who wins.” I've just seen a lot of Democratic mayors and governors doing it, probably not as many as Republicans. And then, if they come back, it'll surprise on the upside.
Willy Walker: I've run out of time. I've got a thousand things to talk to you about. But one of the interesting things is that I think I'll just do one quick one before we sign off, which is one of the stats that we didn't get to in here Peter, was consumer debt and credit card delinquencies. And while they are up slightly year over year, they're still well below the 30-year trend average of delinquencies. And that's been one point that a lot of investors have been looking at saying, “The consumer's overextended credit card debt is going to go through the roof, or it has actually gotten over $1 trillion of credit card debt outstanding.” But as you've talked about in previous webcasts, don't think of it as it relates to that being real debt. That's people just using credit cards more. But I wanted to talk about that there's a webcast, Peter, that I watched; David Faber mention to me when I was with him last week in New York, and it's the ACQUIRED webcast. And in one of them, they did a deep dive on Visa. And it's this fascinating conversation about Visa and how Visa is now the 11th most valuable company in the world and how they've got this business model that runs 92% gross margins and 60% net margins. And not even Google runs 35% net margins. It's a license to print money. But one of the reasons is that they have avoided regulatory scrutiny, and they've obviously had antitrust cases brought against them by the Justice Department, for them, and Mastercard. And so they're not completely out there with nobody focusing on them. But one of the main reasons why consumers don't get upset about them is because consumers love our credit cards because we spend on them. And then we get all these rewards back and we sit there, we say, “I got all these points from Cap One or from whomever else.” Consumers love credit cards and therefore they're not calling their congressmen or congresswomen and saying, “Oh, this is terrible. I'm getting user fees from my credit card company.” And I just think it's interesting your point about the unions, to the extent that there are certain unions that sit there and say, “Hey, I don't like us going back into the office.” And then the flip side to it is all the other services that benefit from having people pick up trash, from having offices being cleaned, from public transportation actually being used again. They sit there and say, “No, hang on a second, that's not beneficial to me.” And therefore there is some political will to push you into those harder issues, if you will.
Dr. Peter Linneman: Yep. Can I give one unrelated thing, related to what we talked, about the suggestion to listeners for free? Which is as the rate comes down, make sure that the combination of your treasurer and whoever is calculating the interest that the lenders actually are lowering your payment. And that it's not just on cruise control where you're sending in the same amount as last month. This is if you have floating-rate debt. And people listen to that, and they say, “Really? Trust me, I've been around a lot.” And the combination of the financial institution and the borrower's sloppiness. Make sure and hopefully, it's not an issue, but just make sure the interest rate comes down appropriately for you.
Willy Walker: So our next conversation, Peter, is in January to reflect back on the close of the year and the last time we were together in Philadelphia. We were talking about the number of interest rate cuts, and there were a lot of people who sat there and said at that time had given up on any cuts this year. And you continued on three. And I have a couple of emails that were choice emails from consistent listeners to this discussion, one of whom wrote to me and said, I give up. I love the conversation. But Peter, still on three cuts this year, there's no way it's ever happening. And I'm giving up on listening to the Walker Webcast. And obviously, we've got one big cut to begin with.
Dr. Peter Linneman: That may even count as too, but we won't go into that.
Willy Walker: I think our bet was on the number of cuts and not the severity of the cuts. We got, you are predicting two more. And so everyone knows. I said to Peter that if we got one cut, I was going to call him a cuckoo clock because he was way off. If we got two cuts, I was going to call him a clock because basically a clock is right twice a day and they're going to be two cuts. And that was what was built in. But if we got three cuts, I would call him a genius, and I would kiss his feet. And so Peter wore a collared shirt today to which he typically wears a T-shirt. So I'm very honored and thankful that you wore a collared shirt today. And I'm sure you're wearing very shiny shoes, which I will gleefully kiss at our next Walker Webcast, which means that I've got to come your way. So I think I'm saying now that I'm coming to Philly in January if we get two rate cuts. I'm looking at Susan Weber, who's in the room with me, and she just looked at me like, “We're going to travel for this one. I will come to you, Peter, and I will kiss those shoes if we get our three rate cuts.”
Dr. Peter Linneman: And all I got to tell you, I've got an old beat-up pair of shoes that I'm taking through the mud, and all the parts fall out in debris, so I'm saving those just for that day.
Willy Walker: I can't wait. I'm going to wear a mask as if we're still in COVID so that my lips don't have to touch the shoe. Peter, as always, is great for the Linneman report as so many folks. I hope everyone appreciates the fact that we delved into politics a little bit today. I don't think Peter, or I want to talk about our own political views or thoughts or what have you, but I do think it was instructive to talk about what's being talked about on the campaign trail and what the actual data is. And then you make your own decisions about who you're going to vote for in November.
Peter, thanks. It's great to see you as always. And thanks, everyone, for joining us today.
Dr. Peter Linneman: My pleasure. Thank you, everyone. Thank you, Willy.
Willy Walker: Take care.
